Outlook 2016: UK Commercial Real Estate

After a strong 2015, we expect performance across different parts of the real estate sectors to be more polarised in 2016.

08/12/2015

Duncan Owen

Global Head of Real Estate

2015 has been another good year for UK commercial real estate and unleveraged total returns are likely to be close to 15%.

Rental recovery

Whilst one of the drivers for another strong year has been a continued favourable fall in real estate yields, the key difference to 2014 is that this year has also seen a broad-based recovery in rental values.

While Central London offices have led the upswing, several other cities including Brighton, Bristol, Cambridge, Manchester, Leeds and Oxford have also seen a significant increase in office rents.

In contrast however, the retail sector is still adjusting to a world of multi-channel sales.

While there are pockets of rental growth in London and some tourist destinations, most centres have a significant amount of vacancy and rents were either flat, or fell slightly in 2015.

Top of the cycle?

The outlook for 2016 is already categorised by some commentators asking whether we are now at the top of the cycle.

The income from commercial real estate has historically been very stable, but capital values have been cyclical (albeit less volatile than equities).

However, capital values have risen by 25% in less than three years - so, surely, this cannot continue?

This sentiment is understandable, but not necessarily rational.

The immediate trigger for previous downturns has been a recession, which has depressed rents and pushed up real estate yields as investors have withdrawn from the market and liquidity has dropped.

In addition, commercial real estate has had a habit of contributing to its own downfall, either through excessive borrowing which inflated prices (e.g. 2005-2007), or because of a boom in development which left an over-supply of space (e.g. 1988-1990) and falls in rents.

Supportive economic picture

Fortunately, none of the usual suspects appear to yet be evident.

Looking at the economy, the outlook is positive and the consensus is that UK GDP will grow by 2.25-2.50% through 2016-2017.

The main reason for being optimistic is that the UK is finally seeing a recovery in productivity, which should support a steady increase in real disposable incomes and consumer spending.

Furthermore, exporters stand to gain from faster growth in the rest of the EU, which accounts for 45% of total exports.

Borrowing under control

Similarly, there are few signs of excess borrowing.

In general, banks and other lenders have continued to take a disciplined approach to commercial real estate and although total loan originations in 2015 are likely to be around £50 billion, they are still well below the peak of £80-90 billion reached in 2006-2007.

Moreover, while the IPD All Property Index initial income yield is low by historical standards at 5%, it is still comfortably above the yield on 10-year gilts at 2% and the consensus is that 10-year gilt yields are unlikely to rise to 3% until at least 2018.

Development low

The final reason for being sanguine is that new commercial development remains at a low point in most markets.

The only grounds for concern being the City of London, where a number of new offices are due to complete in 2018-2019.

Even so, these levels of development are well below previous cycles.

The lack of new development reflects in part the reluctance of banks to fund speculative schemes and in part the hollowing out of the development industry during the last financial crisis.

Employment in construction is still 10% below its pre-crisis peak.

Also, another constraint on development in the commercial sector is sites being instead used for residential development.

Polarised performance in 2016

On balance, given that all the usual suspects have a good alibi, we think that capital values are likely to rise in 2016, but at a slower pace than in 2014-2015.

We anticipate that total returns will still be respectable at between 7-9%.

There are, of course, risks around this outlook.

One possibility is that 10-year gilt yields jump more sharply in 2016 than anticipated.

A second risk is the EU referendum. If the UK were to leave, then UK real estate could be hit as various investment banks and institutions, as well as some manufacturers, switch to continental European locations.

The best market returns will be achieved by real estate which is in the right city, the right location and which best suits occupiers’ requirements and maximises their productivity.

The outlook from this point in the cycle is therefore set for more polarised performance across different parts of the real estate sectors.

Important Information

This site is designed for Institutional Investors. We define "Institutional Investors" as Institutions with the appropriate expertise and knowledge eg Asset Managers, Distributors and Financial Advisors. You should not use this site if you do not fall within this category.

Schroder Investment Management (Luxembourg) S.A. only gives information on its products and services and does not provide investment advice based on individual circumstances. If you are in any doubt about whether an investment is suitable, you should seek independent advice.

Please read this disclaimer below and agree to the terms before you can access the website.

Past performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested. Any past performance figures shown are not indicative of future performance. Exchange rate may vary and cause the value of international investments to rise or fall. The levels and reliefs from taxation may change. Tax reliefs referred to are those currently available and their value depends on the circumstances of the individual investor. Investment in emerging markets involves a high degree of risk. Investment in any sub-fund mentioned herein should not be made without careful reference to the relevant prospectus. The information contained in these pages does not form part of any contract, nor can you rely on it for any contractual purpose.

The information contained on this site is not an invitation to subscribe. Subscriptions will only be received and shares issued on the basis of a fund's current prospectus and the latest audited annual report. Copies of each fund's current prospectus and the latest audited annual report may be obtained from Schroder Investment Management (Luxembourg) S.A. or your Schroders branch office.

Schroder Investment Management (Luxembourg) S.A is regulated by the Commission de Surveillance du Secteur Financier (CSSF) and is subject to the law of 17 December 2010, chapter 13. Schroder International Selection Fund, Schroder Alternative Solutions and Schroder GAIA are subject to the Luxembourg law dated 17 December 2010.

Disclaimer of Warranty and Limitation of Liability.

Schroder Investment Management (Luxembourg) S.A believes that the provided information is accurate as at the date of publication but no warranty of accuracy is given and no liability in respect of any error or omission by a third party is accepted by Schroder Investment Management (Luxembourg) S.A or its affiliates or any director or employee of Schroder Investment Management (Luxembourg) S.A or its affiliates.

In the event of any provision of these Terms and Conditions being deemed unenforceable, the remaining terms and provisions shall be unimpaired and the unenforceable term or provision shall be replaced by an enforceable term or provision that comes closest to the intention underlying the unenforceable term or provision.

Schroder Investment Management (Luxembourg) S.A may modify these Terms and Conditions at any time, with immediate effect and without prior notice.

Privacy

Schroder Investment Management (Luxembourg) S.A is as concerned as you are about the privacy of any personal information you may provide to us through this site. When you visit this site, you are not required to provide us with any personal information other than your country of residence, unless you choose to do so. Our web server will not recognize your domain name or e-mail address, only your indicated country of residence.

Schroders’ web sites use "cookies" for collecting user information from certain pages of the web sites. By "cookie" we mean the small text file that is stored on the hard disk of a computer by the web browser on a computer. It contains information sent by the web server of the web site that a user has visited. A cookie identifies users and can store information about them and their use of a site. Schroders uses cookies to keep track of user activity and to store a user’s username and password to allow the user access to some of its protected web sites. The information derived from cookies enables Schroders to identify which areas of the web site are more interesting so that we can improve our web sites and the information we provide to users. The cookies that Schroders uses to store user name and passwords are encrypted and cannot be read. A user can choose not to accept certain cookies by turning this feature 'off' within the browser settings, however doing this may detract from 'user experience' of certain web sites or even prevent access to some of our websites.

Use of Links

The Website may contain links to Websites published by third parties. Links to this Website may also be included on third party Websites. Schroder Investment Management (Luxembourg) S.A has not reviewed any of the third party Website which link to the Website or to which the Website links. It is not responsible for the content to be found directly or indirectly on any third-party website nor does it endorse or recommend the products and services presented on any such third-party website. Following links to any third-party website or pages shall be at your own risk.

The Website and the information or other material contained in it are not directed to, or intended for distribution to, or use by, any person or entity who is a citizen or resident of, or incorporated or located in any jurisdiction where such distribution, publication, availability or use would be contrary to local laws or regulations, or where Schroder Investment Management (Luxembourg) S.A would infringe any registration or licensing requirement within such jurisdiction.

Electronic Mail Function

The possibility to communicate by E-mail between you and Schroder Investment Management (Luxembourg) S.A is only a convenience granted by Schroder Investment Management (Luxembourg) S.A. You acknowledge the limitations on the reliability of delivery, timeliness and security of internet E-mail and understand that Schroder Investment Management (Luxembourg) S.A will not be responsible for any loss or damage that could result from your requests not being accepted, confirmed or processed or as a result of your E-mails being intercepted by third parties. As a result of these concerns, you should not send sensitive information by E-mail, which may not be secure. If you do so, you do it at your own risk.

Intellectual Property Rights

The information and materials contained in the Website are protected by intellectual property rights, which are owned or claimed by Schroder Investment Management (Luxembourg) S.A, its affiliated entities or third parties. The information and materials may be displayed and printed exclusively for your personal, non-commercial use, provided that you do not remove any intellectual property right or other notices therein. You agree not to transmit, reproduce or sell the information and materials contained in this Website in whatever form and by whatever means without the express prior written consent of Schroder Investment Management (Luxembourg) S.A.

Applicable Law and Jurisdiction

Your access to, visit to and use of the Website, and the present Terms and Conditions are governed by and shall be construed in accordance with Luxembourg law. The Courts of Luxembourg shall have exclusive jurisdiction over any dispute relating thereto, without prejudice to the choice of Schroder Investment Management (Luxembourg) S.A for having any other court jurisdiction over such a dispute under any applicable law.

MSCI Disclaimer:Source: MSCI

The information obtained from MSCI and other data providers, included in reports available from this website, may only be used for your internal use, may not be reproduced or re-disseminated in any form and may not be used to create any financial instruments or products or any indices. The MSCI information and that of other data providers is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling or creating any MSCI information (collectively, the “MSCI Parties”) and other data providers, expressly disclaim all warranties (including, without limitation any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party or other data provider have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages.